Since the Reserve Bank of New Zealand first formerly targeted inflation rates roughly 25 years ago, other central banks around the globe have followed suit; that is, many banks have been setting medium-term rates that prices should rise on an annualized basis, and then presenting those percentages publicly.
Two-and-a-half years back, the U.S. Federal Reserve, placed that percentage at 2%. Yet the U.S. has failed to hit the bulls-eye. Trillions in electronically created dollars over 30 some-odd months, coupled with zero percent overnight lending rates during the Fed’s inflation targeting period, and the U.S. is still a long way from the stated goal.
In spite of the media hype that surrounds the notion of imminent Fed rate hikes, history suggests that the Fed will need to remain exceedingly “patient.” In the quarter century of inflation targeting (at least as far as I have been able to determine), the Fed has never kicked off a rate tightening period when inflation sat below 2%.
In truth, the Fed is not oblivious to the fact that dogged determination to move towards the normalization of overnight lending rates is more likely to hinder economic progress than ensure price stability or advance employment objectives. Who but a few members of Congress will grumble at Janet Yellen’s Fed deciding to push back into Q3 or Q4? After all, haven’t we already lived with zero percent rate policy (ZIRP) for six-plus years?
As much as the Fed might like to get us all off the drug of ultra-low borrowing costs, there are other risks with raising rates too soon. With both Japan and Europe injecting trillions of QE dollars in an effort to boost inflation and improve economic prospects abroad, the money inevitably finds its way into market-based securities of relative value. The German 10-year? 0.35%. Spain? 1.3%. What overseas institution or money manager would not look at those 10-year yields and consider the safety of U.S. 10-year treasury bonds at 1.8% instead? Or our ultimate safe haven prospect, the 30-year at 2.37%.
Granted, those are obscenely low yields that barely compensate for historical cost of living. On the other side of the ledger, though, the U.S. bond market has plenty of room to run on price before comparable yields match those of overseas sovereign debt securities. Yet these facts epitomize the Fed’s dilemma. The 30-Year ($TYX):10-Year ($TNX) spread has moved from 0.90 one year earlier to 0.57 today; the spread between the 10-Year and the 2-Year has shifted from 2.43 to 1.28. The yield curve continues to compress, and may get close to partial inversion if the Fed fails to exercise patience.
Inverted yield curve? Partial inversion? What’s the big deal? Well, you’re talking about a circumstance where the odds of a domestic recession increase dramatically. Inverted yield curves have a near-perfect record of forecasting recessions in the U.S. For that matter, raising local rates before determining whether Europe, Japan and the rest of the world are capable of escaping respective recessions and stagnation is akin to suggesting the U.S. is self-sustaining island. Decoupling theories notwithstanding, the well-being of the United States is still very much dependent on what happens on the world stage –from China to Russia to Germany to Saudi Arabia.
The investing implications may be as simple as supply and demand. Wouldn’t intermediate and long-term rates naturally go higher if demand for government bonds were waning? Similarly, with prominent proxies like the German 2-year heading further and further into negative returns, why on earth would foreign institutions and/or wealthy foreigners stop buying U.S. debt? Vanguard Long-Term Bond (BLV) is still a winner when it comes to the probability of price gains. Meanwhile, if you’re looking to ensure higher monthly distributions, munis still offer relative value. SPDR Nuveen Muni (TFI) works, and for those who welcome a little leverage and are not afraid of some volatility in the space, consider closed-end muni bond funds like Nuveen Muni Opportunity (NIO) or Eaton Vance National Muni Opportunity (EOT).